19 March 2007

Insurance is a rip-off

Before you get the idea that I just figured this out (and because of my business education,) let me assure you that I’ve been of this opinion for quite a long time now. I’ve just recently become aware of otherwise intelligent people around me buying silly insurance policies such as extended warranties and mobile phone insurance—I thought everyone was already aware of what a waste of money these are. As Groening, et al derisively had Homer say when Dr. Nick restored his stupidity in episode BABF22: “Extended warranty? How could I lose?”

Before we begin, let me be clear about my thesis: insurance is too often assumed to always be a prudent purchase that demonstrates the purchaser is a good, disciplined adult. I therefore propose that, at least as a first approximation, we assume that insurance is always a bad investment since, by definition, the average buyer—in the long run—will pay more in premiums than he or she will incur claims (otherwise the insurance company would go out of business, right?) Furthermore, since we can't predict catastrophic events, we can never time when to buy a policy (or let it lapse.) Therefore we commit ourselves to a periodic (most often monthly) expense for the rest of our lives, and this is the worst part: we never see this money again... it's really gone...we could have saved it or at least spent it more prudently, on something that would benefit us or our family now.

Let’s start with the basics: insurance is a financial instrument used by individuals and organizations to protect themselves against a risk (a greater potential financial loss.) You pay a (relatively) small amount of money over time to protect yourself against a possible catastrophic monetary loss. The insurance industry hire actuaries to determine the likely amount and frequency of payouts, adds their (hefty) profit margin, and comes up with the premium to the policyholder. (Granted, this is a simplified view.) Therefore, before we even get into paying middle men (agents/brokers) and for insurance fraud, you will always pay more in the long run with insurance than without, unless you happen to be one of the few exceptions that does indeed experience a catastrophic loss that the carrier actually covers (and, by definition, you can't possibly know if you are going to suffer a catastrophic loss.) To those that say “I know that I'm a unlucky person, so I will buy the best insurance”, I hear “I'm a careless person” and rest assured the insurance company will learn this and cut you off before long.

HEALTHThis is probably the most sensible—and, in fact, prudent—insurance out there. Since you can quickly incur tens or even hundreds of thousands of dollars of expenses due to a serious illness or injury, you need to protect yourself from the financial devastation this would create. Note: despite the perception that insurance is required to be treated in our mostly private health care system, insurance is actually for protecting your assets and credit standing after being treated for a major illness or injury. Even the prestigious Mayo Clinic regularly serves the indigent local population of Rochester, Minnesota knowing they will never be paid for their services. This is the law in the US; hospitals cannot refuse service to anyone in need. Of course, this causes a major problem; hospitals must charge those that can pay more to offset these losses. As a result, conscientious people with health insurance are underwriting the whole system.

Therefore, it is reasonable to propose a reform that would include everyone in the coverage and payment pool. However, I am not naïve enough to think that a single-payer system would necessarily put a dent in our outrageous health care costs (15% of GDP!) I am afraid that trading the corporate profiteering of our current (private) model for the bureaucratic inefficiencies of a single-payer system would do little to reduce cost; sadly, limiting (that is rationing) health care is the only way, and Americans will not stand for this—so expect no change here.

By the way, dental insurance is overrated; suppose you visit the dentist every six months for a cleaning and pay $70 each visit. With insurance, you may pay only a $10 co-pay, and the insurance plan may have negotiated a lower price—let’s say $50. So their payout is at least $100 per year; what do you think they will charge you (or your employer) as an annual premium? I don’t think it would be a stretch to assume that it would be more than $140—so where is the savings?

LIABILITYThe second prudent choice in insurance is liability insurance for your home, vehicle, and business. In our litigious society, you could lose everything in a court judgment, even if you are not at fault by any reasonable person’s estimation. The solution to the growing cost of liability insurance (especially professional malpractice insurance) is tort reform—but I don’t see that happening soon, since our legislators are usually lawyers, and the legal community has immense influence in government at all levels.

LIFELife insurance was designed to allow a family to live on with the same standard of living after the death of the breadwinner. This still makes sense for a modern, dual-income family, but these policies are being over-sold. The most egregious example of this excess is the marketing of policies for children; I find this disgusting! How can money ever alleviate the anguish of losing a child? Generally, you should only buy term life insurance to cover the loss of family income from yourself and/or spouse until your children are of age; in this age of equality of the sexes, your spouse will be able to support himself/herself after that, right? I see no reason why a family member’s death should be treated like a lottery windfall—in fact I find this concept revolting.

I understand that a funeral can be costly, but it’s not an open-ended expense; you can cap this under $5000—something that could be covered by a “rainy day” fund—money that is accumulated when it is no frittered away in premiums to an insurance company for an occurrence that is very unlikely to happen to a relatively young person.

DISABILITYThere is normally some kind of disability coverage in a life and/or health insurance policies, but what is becoming more popular is short-term disability policies to “help pay the bills” while one is out of work due to an injury/illness. While this sounds to be a prudent policy for working class people, it is just one more drain on their already overstretched budget. From what I can tell, the rise in popularity of this type of policy is due entirely to the massive advertising campaign of one particular company and it’s spokes-duck.

HOMESince most homeowners have a mortgage on their property, the lender usually requires homeowners (fire) insurance; they know that if your home were destroyed, (or uninhabitable) you would have little incentive to continue making mortgage payments. This is reasonable; most people don’t have an extra $50,000-$100,000 lying around to rebuild a house in this case. However, I see no reason to pay extra to insure the content of you home—you really don’t have to replace all that junk you’ve collect over the years, do you? The same goes for renter’s insurance; if your apartment burns down—taking your nice, new plasma TV with it—you certainly would appreciate having a policy that would let you replace this. However, can you honestly justify paying a monthly premium to protect this and other non-essential belonging against something that is such a rare occurrence?

AUTOLiability insurance is required by the state (to cover damages/injury you may cause), and a lender will require you to buy collision (your own fault) & comprehensive (acts of nature) insurance. Eventually though, you will own an automobile outright, and I posit that by this time you will be financially secure enough to self-insure repairs to your own car. It will really hurt when you dent your own bumper and have to pay for it out of your own pocket, (especially if it’s a brand new car) but you will certainly save money over the course of your lifetime.

RECCOMENDATIONSThis list could go on and on, so I will just stop here and say that every other type of policy (at least for individuals) is a waste of money! All these other policies and add-ons add up and start to cost real money, and worse—it is a recurring expense that you will pay every month for the rest of your life. You are much better off to set aside this money in a “rainy day” fund for several reasons:

If no major calamity ever transpires, you still have the money.

This “rainy day” fund will eventually become a sizable investment that starts earn money on its own, that then can be used for other purposes (college fund, real estate down payment, retirement, etc.)

Best of all, you will never have to jump through hoops and fight for a payout.

So, here is my recommendation on what policies to buy:

You need health insurance, but go with the highest deductible you can; you will get less in payouts, but the lower premium costs will offset this.

If—and only if—you have dependents, and you contribute significant finances or labor (child care) to your family, buy term life insurance for yourself and/or spouse, so that your family can live in relative comfort in the unlikely event of your early demise. Once these “dependents” are independent, cancel the policy.

Ensure you have liability insurance to shield you assets from seizure by court judgments; this means home, car, and malpractice if applicable.

Carry insurance that the state and your lender may require for your home and car, but run the numbers on the cost and possible benefit of any additional insurance.

Generally speaking, don’t buy any other kind of insurance; especially don’t insure anything you can live without.

Always shop around.

A lot of insurance companies market themselves as a comprehensive service that “takes care of you” in a time of need (e.g. arranging a rental car after an auto accident); I don’t understand why anyone would want to pay extra for this (oh, you don’t think they incorporate that into their premiums?) I just want a bare bones insurance company that just processes legitimate claims as efficiently as possible. I will talk more about this later, in my “Responsible Insurance Company” post.

DISCLAIMER: This should not be construed to be professional financial advice; it is merely a thought-provoking suggestion for intelligent and financially disciplined individuals.